What Is a Control in an Audit? Its Purpose and Types

An audit control, more formally known as an internal control, is a mechanism implemented by an organization to manage risks and achieve its operational, reporting, and compliance objectives. These controls are foundational to ensuring the accuracy and reliability of financial information. They help safeguard assets, prevent fraud, and ensure a company’s financial statements are trustworthy. Internal controls contribute significantly to maintaining the integrity of an organization’s financial health.

Understanding Internal Controls

Internal controls are systems, processes, and procedures organizations put in place to protect assets, ensure accurate financial records, and promote operational efficiency. They function as a framework of checks and balances designed to maintain the integrity of financial information while preventing errors and fraud.

Internal controls can be preventative or detective, working in unison to remedy existing problems and help avoid future ones. For instance, requiring two signatures on a check for payments over a certain amount prevents unauthorized disbursements. Reconciling bank statements against internal cash records helps identify discrepancies after they have occurred. These controls ensure accuracy by establishing verification procedures and enhance operational efficiency by streamlining processes.

Categories of Internal Controls

Internal controls are categorized by their function and how they are implemented. Understanding these distinctions is important for recognizing how different controls contribute to a comprehensive system.

Preventive Controls

Preventive controls are proactive measures designed to stop errors or fraud before they occur. They aim to deter undesirable activities by establishing procedures and safeguards upfront. Common examples include segregation of duties, where responsibilities are divided among different employees so no single person has complete control over a transaction from beginning to end. Authorization limits, which require approval for transactions exceeding a certain amount, also serve as preventive controls, as do controlled access to accounting systems and physical access restrictions to valuable assets.

Detective Controls

Detective controls are designed to identify errors or fraud after they have occurred, allowing for timely corrective action. These controls act as a second line of defense, aiming to uncover problems promptly so they can be corrected or mitigated. Examples include bank reconciliations, which compare bank statements with internal cash records to find discrepancies, physical inventory counts, which verify that recorded quantities match actual stock, and internal audits and reviews of performance, comparing actual results to budgets or forecasts.

Manual vs. Automated Controls

Controls can also be classified based on how they are performed. Manual controls are executed by people, often involving human judgment and intervention. Automated controls are embedded within information systems and are performed entirely by the computer system. These might include system-based checks that prevent data entry errors or automatically flag transactions exceeding predefined limits.

Auditor Interaction with Controls

External auditors play a significant role in evaluating an organization’s internal controls during a financial audit. The auditor’s primary responsibility is to understand the client’s internal control system to assess the risk of material misstatements in the financial statements. This understanding helps auditors determine the nature, timing, and extent of their substantive testing procedures. A robust system of internal controls allows auditors to potentially reduce the volume of detailed transaction testing, leading to a more efficient audit.

Auditors assess internal controls through various procedures:
Inquiry involves asking questions of knowledgeable individuals within the organization to understand processes and controls.
Observation includes watching employees perform their duties or observing processes to see if controls are working as described.
Inspection involves examining documents, records, or physical assets to gather evidence about control effectiveness.
Re-performance means independently executing procedures or controls that were originally performed by the company’s personnel to test their accuracy and effectiveness.

The effectiveness of internal controls directly influences the auditor’s control risk assessment. If controls are strong and operating effectively, the auditor may assess control risk as lower, which can then reduce the amount of detailed substantive testing required. Conversely, if controls are weak or ineffective, the auditor will assess control risk as higher and will need to perform more extensive substantive testing to ensure the financial statements are free from material misstatement. This systematic approach ensures audit evidence gathered is sufficient and appropriate to form an opinion on the financial statements.

Elements of a Strong Control System

An effective internal control system is composed of several interrelated elements that work together to provide reasonable assurance regarding the achievement of an organization’s objectives.

Control Environment

The control environment sets the overall tone of an organization, influencing the control consciousness of its people. This includes the integrity and ethical values demonstrated by management, their commitment to competence, and the way authority and responsibility are assigned. A strong control environment fosters a culture where employees understand and value internal controls, which is foundational for all other control components.

Risk Assessment

Risk assessment involves identifying and analyzing risks relevant to achieving financial reporting objectives. Organizations must regularly assess and identify potential risks or losses, and based on these findings, implement controls to contain or monitor those risks. This process helps management understand where the organization is most vulnerable and where controls are most needed.

Control Activities

Control activities are the policies and procedures that help ensure management directives are carried out to address identified risks. These activities occur throughout the organization at all levels and in all functions. They include a range of actions such as:
Approvals
Authorizations
Verifications
Reconciliations
Reviews of operating performance
Security of assets
Segregation of duties
These activities are the specific actions taken to mitigate risks.

Information and Communication

Information and communication ensure that relevant information is identified, captured, and communicated in a form and timeframe that enables people to carry out their responsibilities. This includes internal communication, flowing up, down, and across the organization, and external communication with outside parties as needed. Effective communication ensures that employees understand their roles in the control system and that management receives the necessary information for decision-making.

Monitoring Activities

Monitoring activities involve ongoing evaluations and separate evaluations to determine whether controls are present and functioning effectively. This process assesses the quality of the internal control system’s performance over time. Monitoring can include routine management and supervisory activities, comparisons, reconciliations, and periodic evaluations by internal audit. This continuous oversight ensures that the internal control system remains adaptive and effective in addressing evolving risks.